Taking the Real Estate discussion further, we will now look into various tax benefits of this type of investment. An individual gets the advantage of tax benefits whenever he/she purchases a property. Property tax is deducted from an individual’s income if they own a property. On the other hand, a certain amount of interest is deducted when paying mortgages.
Over time, a property depreciates, but the value goes down only on paper. The building itself might need maintenance after a while, and this is generally when the property has depreciated. There is always a loss on the rental property, at least on paper due to depreciation. The IRS sets up a % of how much to depreciate each year. A residential property will depreciate over 27.5 years, whereas, a commercial property depreciates over 39 years. Each year the property holder needs to take out a certain amount from their rental income and deduct it as depreciation amount.
Categories of Real Estate Investors
Passive: Least benefits are present to the investors in this category
Active: This allows investors to deduct additional dollars against their ordinary income. The investor will not be able to take benefit from this if the adjusted gross income does not match the criteria - married: income higher than $150K or single: higher than $100K.
Real Estate Professional: High Salaried professionals classify themselves in this category. The professional can offset 100% of all the real estate losses against their regular income.
Either you or your spouse must meet two requirements to classify as Real Estate professionals.
The taxpayer or spouse should spend most of their time in real estate business and the taxpayer must spend 750 hours or more in property business and rentals.
When the capital gain tax is calculated in the long run, depreciation can be troublesome for you. The calculation for Capital Gain Tax is, selling price minus adjusted tax basis (inclusive of depreciation). The capital gains tax is around 15% and the federal ordinary income tax is 39% (as of 2019). And thus the capital gains tax is comparatively much lower. However, you don’t need to worry about capital gain tax! There are ways to avoid it.
1031 Exchange: This strategy allows an investor to defer paying capital gains taxes, as long as another property is purchased with the profits gained by the sale of the first property
Convert rental property to personal property: There is a criterion which includes living in the property for a certain number of years and so you can classify it as your personal property (varies from state to state).
Tax benefits might hurt some investors and benefit others. Tax laws change frequently and new laws keep coming as the government changes. However, it is essential to keep yourself updated with all the tax laws.